The following invention relates to a method and system for managing risk and, in particular, for precisely hedging the risks associated with a plurality of financial transactions.
Transactions involving financial instruments generally have associated therewith a number of risk factors. For example, a foreign exchange (“FX”) forward transaction, in which there is an agreement to buy one currency against another currency at a specified future date at an agreed upon price, includes an interest rate risk factor (the absolute value of each currency may change) and an FX risk factor (the exchange rate may change by the future date). Other transaction types present different risk factors including, by way of non-limiting example, collateral risk, volatility risk individually as well as in various combinations.
Traders engaging in such transactions try to minimize the risk factors by using various hedging techniques. For example, a trader trading on behalf of a financial institution may engage in numerous transactions that each require the trader to pay out a certain sum of U.S. dollars at a future date. In order to eliminate the risk in the trader's book associated with the possible fluctuation of U.S. interest rates, the financial institution deposits in an interest bearing account an amount of U.S. dollars that will equal the total sum of U.S. dollars the trader is required to pay on the future date. In this way, the interest rate risk associated with the trader's positions is removed from the trader's book and is carried by the financial institution. The financial institution performs a similar hedging transaction for all its traders so that the total interest rate risk generated by trading on behalf of the financial institution is aggregated in a single interest rate risk book. The financial institution may then engage in additional transactions to hedge the risk associated with the interest rate book.
The typical procedure used to hedge the risk associated with a trader's book is to “net out” the trader's positions per instrument class and hedge the risks associated with each instrument class. So, for example, if the trader has five FX forward positions in which the trader must deliver a total of $120M US by January 27th, a hedging transaction is performed in which the financial institution deposits into a money market account a sufficient amount US dollars so that $120M US is available by January 27th. Thus, the trader's entire interest rate risk associated with the trader's FX forward positions is transferred to the financial institution's interest rate risk book. Similarly, the risks on the trader's book associated with other instrument classes, such as, for example, swaps and money markets, are hedged and transferred to the risk books of the financial institution.
Several inefficiencies exist with hedging a trader's book in this manner. First, the process of netting all a trader's positions in a particular instrument class, for example FX forward contracts, to determine the trader's interest rate risk in US dollars ignores the different FX risks that may be associated with each FX forward contract. For instance, the trader's FX forward positions may include US/CHF and US/JPY forwards that each present a different FX risk. While netting all the trader's FX forward contracts is useful in hedging the trader's US interest rate risk, it does not account for the trader's FX risks associated with the US/CHF and US/JPY exchange rates.
Furthermore, because the netting of the trader's book and the transfer of the risk on the trader's book to the financial institution's risk book occurs periodically, perhaps once a week, the hedge at the end the period reflects the risks at the time of the hedge but may not accurately reflect the risks that existed at the time of the trade. For example, if the interest rate risk associated with a trader's FX forward contracts are netted and hedged once a week, then any hedging transaction at the end of the week may not precisely hedge the interest rate risk of each FX forward contract if interest rates varied during the week. Such imprecise hedging may expose the financial institution to significant risks, especially as the number of transactions to be hedged increases.
Accordingly, it is desirable to provide a method and system for precisely hedging the risks associated with financial transactions.